Performance Measurement in Decentralized Organizations: Solutions To Questions

Chapter 11 Performance Measurement in Decentralized Organizations
Chapter 11
Performance Measurement in Decentralized
Organizations
Solutions to Questions
11-1 In a decentralized organization, decision-making authority isn’t confined to a few top executives;
instead, decision-making authority is spread throughout the organization.
11-2 The benefits of decentralization include: (1) by delegating day-to-day problem solving to lower-
level managers, top management can concentrate on bigger issues such as overall strategy; (2)
empowering lower-level managers to make decisions puts decision-making authority in the hands of
those who tend to have the most detailed and up-to-date information about day-to-day operations; (3)
by eliminating layers of decision-making and approvals, organizations can respond more quickly to
customers and to changes in the operating environment; (4) granting decision-making authority helps
train lower-level managers for higher-level positions; and (5) empowering lower-level managers to make
decisions can increase their motivation and job satisfaction.
11-3 The manager of a cost center has control over cost, but not revenue or the use of investment
funds. A profit center manager has control over both cost and revenue. An investment center manager
has control over cost and revenue and the use of investment funds.
11-4 Margin is the ratio of net operating income to total sales. Turnover is the ratio of total sales to
average operating assets. The product of the two numbers is the ROI.
11-5 Residual income is the net operating income an investment center earns above the company’s
minimum required rate of return on operating assets.
11-6 If ROI is used to evaluate performance, a manager of an investment center may reject a
profitable investment opportunity whose rate of return exceeds the company’s required rate of return but
whose rate of return is less than the investment center’s current ROI. The residual income approach
overcomes this problem because any project whose rate of return exceeds the company’s minimum
required rate of return will result in an increase in residual income.
11-7 The difference between delivery cycle time and throughput time is the waiting period between
when an order is received and when production on the order is started. Throughput time is made up of
process time, inspection time, move time, and queue time. Process time is value-added time and
inspection time, move time, and queue time are non-value-added time.
11-8 An MCE of less than 1 means that the production process includes non-value-added time. An
MCE of 0.40, for example, means that 40% of throughput time consists of actual processing, and that the
other 60% consists of
11-1
moving, inspection, and other non-value-added activities.
11-9 A company’s balanced scorecard should be derived from and support its strategy. Because
different companies have different strategies, their balanced scorecards should be different.
11-10 The balanced scorecard is constructed to support the company’s strategy, which is a theory
about what actions will further the company’s goals. Assuming that the company has financial goals,
measures of financial performance must be included in the balanced scorecard as a check on the reality
of the theory. If the internal business processes improve, but the financial outcomes do not improve, the
theory may be flawed and the strategy should be changed.
11-2
Exercise 11-1 (10 minutes)

1. Net operating income
Margin =
Sales
$5,400,000
= = 30%
$18,000,000
2. Sales
Turnover =
Average operating assets
$18,000,000
= = 0.5
$36,000,000
3. ROI = Margin × Turnover

= 30% × 0.5 = 15%
11-3

Average operating assets...................... £2,200,000
Net operating income............................ £400,000
Minimum required return:
16% × £2,200,000............................. 352,000
Residual income.................................... £ 48,000
11-4

1. Throughput time = Process time + Inspection time + Move time +
Queue time
= 2.8 days + 0.5 days + 0.7 days + 4.0 days
= 8.0 days
2. Only process time is value-added time; therefore the manufacturing

cycle efficiency (MCE) is:
Value-added time 2.8 days
MCE= = =0.35
Throughput time 8.0 days
3. If the MCE is 35%, then 35% of throughput time was spent in value-
added activities, the other 65% was spent in non-value-added activities.
4. Delivery cycle time = Wait time + Throughput time

= 16.0 days + 8.0 days
= 24.0 days
5. If all queue time is eliminated, then the throughput time drops to only 4
days (0.5 + 2.8 + 0.7). The MCE becomes:
Value-added time 2.8 days
MCE= = =0.70
Throughput time 4.0 days
Thus, the MCE increases to 70%. This exercise shows quite dramatically
how lean production approach can improve operations and reduce
throughput time.
11-5

1. MPC’s previous manufacturing strategy was focused on high-volume
production of a limited range of paper grades. The goal of this strategy
was to keep the machines running constantly to maximize the number
of tons produced. Changeovers were avoided because they lowered
equipment utilization. Maximizing tons produced and minimizing
changeovers helped spread the high fixed costs of paper manufacturing
across more units of output. The new manufacturing strategy is focused
on low-volume production of a wide range of products. The goals of this
strategy are to increase the number of paper grades manufactured,
decrease changeover times, and increase yields across non-standard
grades. While MPC realizes that its new strategy will decrease its
equipment utilization, it will still strive to optimize the utilization of its
high fixed cost resources within the confines of flexible production. In
an economist’s terms, the old strategy focused on economies of scale
while the new strategy focuses on economies of scope.
2. Employees focus on improving those measures that are used to evaluate

their performance. Therefore, strategically-aligned performance
measures will channel employee effort towards improving those aspects
of performance that are most important to obtaining strategic
objectives. If a company changes its strategy but continues to evaluate
employee performance using measures that do not support the new
strategy, it will be motivating its employees to make decisions that
promote the old strategy, not the new strategy. And if employees make
decisions that promote the new strategy, their performance measures
will suffer.
Some performance measures that would be appropriate for MPC’s old
strategy include: equipment utilization percentage, number of tons of
paper produced, and cost per ton produced. These performance
measures would not support MPC’s new strategy because they would
discourage increasing the range of paper grades produced, increasing
the number of changeovers performed, and decreasing the batch size
produced per run.
11-6
Exercise 11-4 (continued)

3. Students’ answers may differ in some details from this solution.
Financial
Sales + Contribution +
margin per ton
Customer
Number of new +
customers acquired
Time to fill – Customer satisfaction with +

an order breadth of product offerings
Internal
Business
Processes Number of different +
paper grades produced
Average change- Average

– +
over time manufacturing
yield
Learning
and Growth Number of employees
trained to support the +
flexibility strategy
11-7

4. The hypotheses underlying the balanced scorecard are indicated by the
arrows in the diagram. Reading from the bottom of the balanced
scorecard, the hypotheses are:
° If the number of employees trained to support the flexibility strategy
increases, then the average changeover time will decrease and the
number of different paper grades produced and the average
manufacturing yield will increase.
° If the average changeover time decreases, then the time to fill an
order will decrease.
° If the number of different paper grades produced increases, then the
customer satisfaction with breadth of product offerings will increase.
° If the average manufacturing yield increases, then the contribution
margin per ton will increase.
° If the time to fill an order decreases, then the number of new
customers acquired, sales, and the contribution margin per ton will
increase.
° If the customer satisfaction with breadth of product offerings
increases, then the number of new customers acquired, sales, and
the contribution margin per ton will increase.
° If the number of new customers acquired increases, then sales will
increase.
Each of these hypotheses can be questioned. For example, the time to
fill an order is a function of additional factors above and beyond
changeover times. Thus, MPC’s average changeover time could decrease
while its time to fill an order increases if, for example, the shipping
department proves to be incapable of efficiently handling greater
11-8
product diversity, smaller batch sizes, and more frequent shipments. The
fact that each of the hypotheses mentioned above can be questioned
does not invalidate the balanced scorecard. If the scorecard is used
correctly, management will be able to identify which, if any, of the
hypotheses are invalid and modify the balanced scorecard accordingly.
11-9
1. (b) (c)
Net Average
(a) Operating Operating ROI
Sales Income* Assets (b) ÷ (c)
$4,500,000 $290,000 $800,000 36.25%
$4,600,000 $300,000 $800,000 37.50%
$4,700,000 $310,000 $800,000 38.75%
$4,800,000 $320,000 $800,000 40.00%
$4,900,000 $330,000 $800,000 41.25%
$5,000,000 $340,000 $800,000 42.50%
*Sales × Contribution Margin Ratio – Fixed Expenses
2. The ROI increases by 1.25% for each $100,000 increase in sales. This
happens because each $100,000 increase in sales brings in an additional
profit of $10,000. When this additional profit is divided by the average
operating assets of $800,000, the result is an increase in the company’s
ROI of 1.25%.
Increase in sales.................................................... $100,000 (a)
Contribution margin ratio....................................... 10% (b)
Increase in contribution margin and net operating
income (a) × (b)................................................. $10,000 (c)
Average operating assets....................................... $800,000 (d)
Increase in return on investment (c) ÷ (d).............. 1.25%
11-10

Margin =
Sales
$800,000
= = 10%
$8,000,000
Sales
Turnover =
$8,000,000
= = 2.5
$3,200,000
ROI = Margin × Turnover
= 10% × 2.5 = 25%
11-11

Margin =
Sales
$800,000(1.00 + 4.00)
=
$8,000,000(1.00 + 1.50)
$4,000,000
= = 20%
$20,000,000
Sales
Turnover =
$8,000,000 (1.00 + 1.50)

=
$3,200,000
$20,000,000
= = 6.25
$3,200,000
= 20% × 6.25 = 125%
11-12

Margin =
Sales
$800,000 + $250,000
=
$8,000,000 + $2,000,000
$1,050,000
= = 10.5%
$10,000,000
Sales
Turnover =
$8,000,000 + $2,000,000
=
$3,200,000 + $800,000
$10,000,000
= = 2.5
$4,000,000
= 10.5% × 2.5 = 26.25%
11-13

1. ROI computations:
Net operating income Sales
ROI = ×
Sales Average operating assets
$630,000 $9,000,000
Perth: × = 7% × 3 = 21%
$9,000,000 $3,000,000
$1,800,000 $20,000,000
Darwin: × = 9% × 2 = 18%
$20,000,000 $10,000,000
2. Perth Darwin
Average operating assets.................... $3,000,000 $10,000,000
Net operating income......................... $630,000 $1,800,000
Minimum required return on average
operating assets—16% × Average
operating assets.............................. 480,000 1,600,000
Residual income................................. $150,000 $ 200,000
3. No, the Darwin Division is simply larger than the Perth Division and for
this reason one would expect that it would have a greater amount of
residual income. Residual income can’t be used to compare the
performance of divisions of different sizes. Larger divisions will almost
always look better. In fact, in the case above, Darwin does not appear
to be as well managed as Perth. Note from Part (1) that Darwin has only
an 18% ROI as compared to 21% for Perth.
11-14
Company A Company B Company C

Sales......................................... $400,000 * $750,000 * $600,000 *
Net operating income................. $32,000 $45,000 * $24,000
Average operating assets............ $160,000 * $250,000 $150,000 *
Return on investment (ROI)........ 20% * 18% * 16%
Minimum required rate of return:
Percentage.............................. 15% * 20% 12% *
Dollar amount......................... $24,000 $50,000 * $18,000
Residual income......................... $8,000 $(5,000) $6,000 *
*Given.
11-15

1. Computation of ROI.
$300,000 $6,000,000
Division A: ROI = × = 5% × 4 = 20%
$6,000,000 $1,500,000
$900,000 $10,000,000
Division B: ROI = × = 9% × 2 = 18%
$10,000,000 $5,000,000
$180,000 $8,000,000
Division C: ROI = × = 2.25% × 4 = 9%
$8,000,000 $2,000,000
2. Division A Division B Division C

Average operating assets..... $1,500,000 $5,000,000 $2,000,000
Required rate of return........ × 15% × 18% × 12%
Minimum required return..... $ 225,000 $ 900,000 $ 240,000
Actual net operating income. $ 300,000 $ 900,000 $ 180,000
Minimum required return
(above)............................ 225,000 900,000 240,000
Residual income.................. $ 75,000 $ 0 $ (60,000)
11-16
3. a. and b. Division A Division B Division C

Return on investment (ROI).. . 20% 18% 9%
Therefore, if the division is
presented with an
investment opportunity
yielding 17%, it probably
would................................. Reject Reject Accept
Minimum required return for
computing residual income. . 15% 18% 12%
Therefore, if the division is
presented with an
investment opportunity
yielding 17%, it probably
would................................. Accept Reject Accept
If performance is being measured by ROI, both Division A and Division B
probably would reject the 17% investment opportunity. The reason is
that these companies are presently earning a return greater than 17%;
thus, the new investment would reduce the overall rate of return and
place the divisional managers in a less favorable light. Division C
probably would accept the 17% investment opportunity, because its
acceptance would increase the Division’s overall rate of return.
If performance is being measured by residual income, both Division A
and Division C probably would accept the 17% investment opportunity.
The 17% rate of return promised by the new investment is greater than
their required rates of return of 15% and 12%, respectively, and would
therefore add to the total amount of their residual income. Division B
would reject the opportunity, because the 17% return on the new
investment is less than B’s 18% required rate of return.
11-17

1. ROI computations:
Net operating income Sales
ROI = ×
$90,000 $1,000,000
Eastern Division: × = 9% × 2 = 18%
$1,000,000 $500,000
$105,000 $1,750,000
Western Division: × = 6% × 3.5 = 21%
$1,750,000 $500,000
2. The manager of the Western Division seems to be doing the better job.
Although her margin is three percentage points lower than the margin
of the Eastern Division, her turnover is higher (a turnover of 3.5, as
compared to a turnover of two for the Eastern Division). The greater
turnover more than offsets the lower margin, resulting in a 21% ROI, as
compared to an 18% ROI for the other division.
Notice that if you look at margin alone, then the Eastern Division
appears to be the strongest division. This fact underscores the
importance of looking at turnover as well as at margin in evaluating
performance in an investment center.
11-18

Financial
Profit margin +
Revenue per employee + Sales +
Customer
Number of new +
customers acquired
Customer Customer Customer

satisfaction with + satisfaction with + satisfaction with +
effectiveness efficiency service quality
Internal Business
Processes Average number of –
errors per tax return
Ratio of billable hours + Average time needed to –

to total hours prepare a return
Learning
And Growth
Percentage of job + Employee morale +

offers accepted
Amount of compensation paid + Average number of years –

above industry average to be promoted
11-19

° If the amount of compensation paid above the industry average
increases, then the percentage of job offers accepted and the level of
employee morale will increase.
° If the average number of years to be promoted decreases, then the
percentage of job offers accepted and the level of employee morale
will increase.
° If the percentage of job offers accepted increases, then the ratio of
billable hours to total hours should increase while the average
number of errors per tax return and the average time needed to
prepare a return should decrease.
° If employee morale increases, then the ratio of billable hours to total
hours should increase while the average number of errors per tax
return and the average time needed to prepare a return should
decrease.
° If employee morale increases, then the customer satisfaction with
service quality should increase.
° If the ratio of billable hours to total hours increases, then the revenue
per employee should increase.
° If the average number of errors per tax return decreases, then the
customer satisfaction with effectiveness should increase.
° If the average time needed to prepare a return decreases, then the
customer satisfaction with efficiency should increase.
° If the customer satisfaction with effectiveness, efficiency, and service
quality increases, then the number of new customers acquired should
increase.
° If the number of new customers acquired increases, then sales
should increase.
11-20
° If revenue per employee and sales increase, then the profit margin
should increase.
11-21

Each of these hypotheses can be questioned. For example, Ariel’s
customers may define effectiveness as minimizing their tax liability
which is not necessarily the same as minimizing the number of errors in
a tax return. If some of Ariel’s customers became aware that Ariel
overlooked legal tax minimizing opportunities, it is likely that the
“customer satisfaction with effectiveness” measure would decline. This
decline would probably puzzle Ariel because, although the firm prepared
what it believed to be error-free returns, it overlooked opportunities to
minimize customers’ taxes. In this example, Ariel’s internal business
process measure of the average number of errors per tax return does
not fully capture the factors that drive the customer satisfaction. The
fact that each of the hypotheses mentioned above can be questioned
does not invalidate the balanced scorecard. If the scorecard is used
correctly, management will be able to identify which, if any, of the
hypotheses are invalid and then modify the balanced scorecard
accordingly.
3. The performance measure “total dollar amount of tax refunds

generated” would motivate Ariel’s employees to aggressively search for
tax minimization opportunities for its clients. However, employees may
be too aggressive and recommend questionable or illegal tax practices
to clients. This undesirable behavior could generate unfavorable
publicity and lead to major problems for the company as well as its
customers. Overall, it would probably be unwise to use this performance
measure in Ariel’s scorecard.
However, if Ariel wanted to create a scorecard measure to capture this
aspect of its client service responsibilities, it may make sense to focus
the performance measure on its training process. Properly trained
employees are more likely to recognize viable tax minimization
opportunities.
11-22

4. Each office’s individual performance should be based on the scorecard
measures only if the measures are controllable by those employed at
the branch offices. In other words, it would not make sense to attempt
to hold branch office managers responsible for measures such as the
percent of job offers accepted or the amount of compensation paid
above industry average. Recruiting and compensation decisions are not
typically made at the branch offices. On the other hand, it would make
sense to measure the branch offices with respect to internal business
process, customer, and financial performance. Gathering this type of
data would be useful for evaluating the performance of employees at
each office.
11-23

Margin =
Sales
$16,000
= = 2%
$800,000
Sales
Turnover =
$800,000
= =8
$100,000
= 2% × 8 = 16%

Margin =
Sales
$16,000 + $6,000
=
$800,000 + $80,000
$22,000
= = 2.5%
$880,000
Sales
Turnover =
$800,000 + $80,000
=
$100,000
$880,000
= = 8.8
$100,000
= 2.5% × 8.8 = 22%
11-24

Margin =
Sales
$16,000 + $3,200
=
$800,000
$19,200
= = 2.4%
$800,000
Sales
Turnover =
$800,000
= =8
$100,000
= 2.4% × 8 = 19.2%

Margin =
Sales
$16,000
= = 2%
$800,000
Sales
Turnover =
$800,000
=
$100,000 - $20,000
$800,000
= = 10
$80,000
= 2% × 10 = 20%
11-25
Division
Fab Consulting IT
Sales....................................... $800,000 * $650,000 $500,000
Net operating income............... $72,000 * $26,000 $40,000 *
Average operating assets......... $400,000 $130,000 * $200,000
Margin..................................... 9% 4% * 8% *
Turnover................................. 2.0 5.0 * 2.5
Return on investment (ROI)...... 18% * 20% 20% *
*Given.
Note that the Consulting and IT Divisions apparently have different
strategies to obtain the same 20% return. The Consulting Division has a
low margin and a high turnover, whereas the IT Division has just the
opposite.
11-26
Problem 11-14 (30 minutes)

1. Present New Line Total
(1) Sales......................... $21,000,000 $9,000,000 $30,000,000
(2) Net operating income. $1,680,000 $630,000 * $2,310,000
(3) Operating assets........ $5,250,000 $3,000,000 $8,250,000
(4) Margin (2) ÷ (1)......... 8.0% 7.0% 7.7%
(5) Turnover (1) ÷ (3)..... 4.00 3.00 3.64
(6) ROI (4) × (5)............. 32% 21% 28%
* Sales............................................................. $9,000,000
Variable expenses (65% × $9,000,000)........... 5,850,000
Contribution margin........................................ 3,150,000
Fixed expenses............................................... 2,520,000
Net operating income..................................... $ 630,000
2. Fred Halloway will be inclined to reject the new product line because
accepting it would reduce his division’s overall rate of return.
3. The new product line promises an ROI of 21%, whereas the company’s
overall ROI last year was only 18%. Thus, adding the new line would
increase the company’s overall ROI.
4.
a. Present New Line Total
Operating assets...................... $5,250,000 $3,000,000 $8,250,000
Minimum required return.......... × 15% × 15% × 15%
Minimum net operating income. $787,500 $450,000 $1,237,500
Actual net operating income..... $1,680,000 $ 630,000 $2,310,000
Minimum net operating income
(above)................................. 787,500 450,000 1,237,500
Residual income....................... $ 892,500 $ 180,000 $1,072,500
b. Under the residual income approach, Fred Halloway would be inclined
11-27
to accept the new product line because adding the product line would
increase the total amount of his division’s residual income, as shown
above.
11-28

1. Breaking the ROI computation into two separate elements helps the
manager to see important relationships that might remain hidden. First,
the importance of turnover of assets as a key element to overall
profitability is emphasized. Prior to use of the ROI formula, managers
tended to allow operating assets to swell to excessive levels. Second,
the importance of sales volume in profit computations is stressed and
explicitly recognized. Third, breaking the ROI computation into margin
and turnover elements stresses the possibility of trading one off for the
other in attempts to improve the overall profit picture. That is, a
company may shave its margins slightly hoping for a large enough
increase in turnover to increase the overall rate of return. Fourth, it
permits a manager to reduce important profitability elements to ratio
form, which enhances comparisons between units (divisions, etc.) of the
organization.
2. Companies in the Same Industry

A B C
Sales.................................. $4,000,000 * $1,500,000 * $6,000,000
Net operating income.......... $560,000 * $210,000 * $210,000
Average operating assets..... $2,000,000 * $3,000,000 $3,000,000 *
Margin................................ 14% 14% 3.5% *
Turnover............................. 2.0 0.5 2.0 *
Return on investment (ROI). 28% 7% * 7%
*Given.
NAA Report No. 35 states (p. 35):
“Introducing sales to measure level of operations helps to disclose
specific areas for more intensive investigation. Company B does as well
as Company A in terms of profit margin, for both companies earn 14%
on sales. But Company B has a much lower turnover of capital than
does Company A. Whereas a dollar of investment in Company A
supports two dollars in sales each period, a dollar investment in
Company B supports only 50 cents in sales each period. This suggests
11-29
that the analyst should look carefully at Company B’s investment. Is the
company keeping an inventory larger than necessary for its sales
volume? Are receivables being collected promptly? Or did Company A
acquire its fixed assets at a price level which was much lower than that
at which Company B purchased its plant?”
11-30
Problem 11-15 (continued)

Thus, by including sales specifically in ROI computations the manager is
able to discover possible problems, as well as reasons underlying a
strong or a weak performance. Looking at Company A compared to
Company C, notice that C’s turnover is the same as A’s, but C’s margin
on sales is much lower. Why would C have such a low margin? Is it due
to inefficiency, is it due to geographical location (thereby requiring
higher salaries or transportation charges), is it due to excessive
materials costs, or is it due to still other factors? ROI computations raise
questions such as these, which form the basis for managerial action.
To summarize, in order to bring B’s ROI into line with A’s, it seems
obvious that B’s management will have to concentrate its efforts on
increasing turnover, either by increasing sales or by reducing assets. It
seems unlikely that B can appreciably increase its ROI by improving its
margin on sales. On the other hand, C’s management should
concentrate its efforts on the margin element by trying to pare down its
operating expenses.
11-31

1. a., b., and c.
Month
1 2 3 4
Throughput time in days:
Process time.................................. 0.6 0.5 0.5 0.4
Inspection time.............................. 0.7 0.7 0.4 0.3
Move time..................................... 0.5 0.5 0.4 0.5
Queue time................................... 3.6 3.6 2.6 1.7
Total throughput time.................... 5.4 5.3 3.9 2.9
Manufacturing cycle efficiency (MCE):

Process time ÷ Throughput time..... 11.1% 9.4% 12.8% 13.8%
Delivery cycle time in days:
Wait time...................................... 9.6 8.7 5.3 4.7
Total throughput time.................... 5.4 5.3 3.9 2.9
Total delivery cycle time................. 15.0 14.0 9.2 7.6
2. The general trend is favorable in all of the performance measures

except for total sales. On-time delivery is up, process time is down,
inspection time is down, move time is basically unchanged, queue time
is down, manufacturing cycle efficiency is up, and the delivery cycle
time is down. Even though the company has improved its operations, it
has not yet increased its sales. This may have happened because
management attention has been focused on the factory—working to
improve operations. However, it may be time now to exploit these
improvements to go after more sales—perhaps by increased product
promotion and better marketing strategies. It will ultimately be
necessary to increase sales so as to translate the operational
improvements into more profits.
11-32

3. a. and b.
Month
5 6
Process time........................................ 0.4 0.4
Inspection time.................................... 0.3
Move time............................................ 0.5 0.5
Queue time..........................................
Total throughput time........................... 1.2 0.9
Process time ÷ Throughput time........... 33.3% 44.4%
As a company pares away non-value-added activities, the manufacturing

cycle efficiency improves. The goal, of course, is to have an efficiency of
100%. This will be achieved when all non-value-added activities have
been eliminated and process time equals throughput time.
11-33

Financial Total profit +
Sales +
Customer
Customer Customer
satisfaction with + satisfaction with +
service menu choices
Internal
Business Dining area Average time
Processes cleanliness
+ to prepare an –
order
Average time Number of
to take orders – menu items
+
Learning
and Percentage Percentage
Growth of dining of kitchen
room staff + staff +
completing completing
hospitality cooking
course course
11-34

o If the percentage of dining room staff who complete the hospitality
course increases, the average time to take an order will decrease.
o If the percentage of dining room staff who complete the hospitality
course increases, then dining room cleanliness will improve.
o If the percentage of kitchen staff who complete the cooking course
increases, then the average time to prepare an order will decrease.
o If the percentage of kitchen staff who complete the cooking course
increases, then the number of menu items will increase.
o If the dining room cleanliness improves, then customer satisfaction
with service will increase.
o If the average time to take an order decreases, then customer
satisfaction with service will increase.
o If the average time to prepare an order decreases, then customer
satisfaction with service will increase.
o If the number of menu items increases, then customer satisfaction
with menu choices will increase.
o If customer satisfaction with service increases, sales will increase.
o If customer satisfaction with menu choices increases, sales will
increase.
o If sales increase, total profits for the Lodge will increase.
Each of these hypotheses can be questioned. For example, even if the
number of menu items increases, customer satisfaction with the menu
choices may not increase. The items added to the menu may not appeal
to customers. The fact that each of the hypotheses can be questioned
does not, however, invalidate the balanced scorecard. If the scorecard is
used correctly, management will be able to identify which, if any, of the
hypotheses is incorrect. [See below.]
3. Management will be able to tell if a hypothesis is false if an

improvement in a performance measure at the bottom of an arrow does
11-35
not, in fact, lead to improvement in the performance measure at the tip of

the arrow. For example, if the number of menu items is increased, but
customer satisfaction with the menu choices does not increase,
management will immediately know that something was wrong with
their assumptions.
11-36

1. Operating assets do not include investments in other companies or in
undeveloped land.
Ending Beginning
Balances Balances
Cash....................................... $ 130,000 $ 125,000
Accounts receivable.................. 480,000 340,000
Inventory................................ 490,000 570,000
Plant and equipment (net)........ 820,000 845,000
Total operating assets.............. $1,920,000 $1,880,000
$1,880,000 + $1,920,000
Average operating assets = = $1,900,000
2
Net operating income
Margin =
Sales
$627,000
= = 15%
$4,180,000
Sales
Turnover =
$4,180,000
= = 2.2
$1,900,000
= 15% × 2.2 = 33%
2. Net operating income........................................ $627,000

Minimum required return (20% × $1,900,000).... 380,000
Residual income................................................ $247,000
11-37

The answers below are not the only possible answers. Ingenious people
can figure out many different ways of making performance look better
even though it really isn’t. This is one of the reasons for a balanced
scorecard. By having a number of different measures that ultimately are
linked to overall financial goals, “gaming” the system is more difficult.
1. Speed-to-market can be improved by taking on less ambitious projects.

Instead of working on major product innovations that require a great
deal of time and effort, R&D may choose to work on small, incremental
improvements in existing products. There is also a danger that in the
rush to push products out the door, the products will be inadequately
tested and developed.
2. Performance measures that are ratios or percentages present special

dangers. A ratio can be increased either by increasing the numerator or
by decreasing the denominator. Usually, the intention is to increase the
numerator in the ratio, but a manager may react by decreasing the
denominator instead. In this case (which actually happened), the
managers pulled telephones out of the high-crime areas. This eliminated
the problem for the managers, but was not what the CEO or the city
officials had intended. They wanted the phones fixed, not eliminated.
3. In real life, the production manager simply added several weeks to the
delivery cycle time. In other words, instead of promising to deliver an
order in four weeks, the manager promised to deliver in six weeks. This
increase in delivery cycle time did not, of course, please customers and
drove some business away, but it dramatically improved the percentage
of orders delivered on time.
11-38

4. As stated above, ratios can be improved by changing either the
numerator or the denominator. Managers who are under pressure to
increase the revenue per employee may find it easier to eliminate
employees than to increase revenues. Of course, eliminating employees
may reduce total revenues and total profits, but the revenue per
employee will increase as long as the percentage decline in revenues is
less than the percentage cut in number of employees. Suppose, for
example, that a manager is responsible for business units with a total of
1,000 employees, $120 million in revenues, and profits of $2 million.
Further suppose that a manager can eliminate one of these business
units that has 200 employees, revenues of $10 million, and profits of
$1.2 million.
Before eliminating After eliminating
the business unit the business unit
Total revenue............... $120,000,000 $110,000,000
Total employees............ 1,000 800
Revenue per employee. . $120,000 $137,500
Total profits.................. $2,000,000 $800,000
As these examples illustrate, performance measures should be selected

with a great deal of care and managers should avoid placing too much
emphasis on any one performance measure.
11-39

1. Net operating income Sales
ROI = ×
$80,000 $1,000,000
= ×
$1,000,000 $500,000
= 8% × 2 = 16%
2. $90,000 $1,000,000
ROI = ×
$1,000,000 $500,000
= 9% × 2 = 18%
(Increase) (Unchanged) (Increase)
3. $80,000 $1,000,000
ROI = ×
$1,000,000 $400,000
= 8% × 2.5 = 20%
(Unchanged) (Increase) (Increase)
4. The company has a contribution margin ratio of 40% ($20 CM per unit
divided by $50 selling price per unit). Therefore, a $100,000 increase in
sales would result in a new net operating income of:
Sales..................................... $1,100,000 100%
Variable expenses.................. 660,000 60%
Contribution margin............... 440,000 40%
Fixed expenses...................... 320,000
Net operating income............. $ 120,000
11-40
$120,000 $1,100,000
ROI = ×
$1,100,000 $500,000
= 10.91% × 2.2 = 24%
(Increase) (Increase) (Increase)
A change in sales affects both the margin and the turnover.
5. Interest is a financing expense and thus is not used to compute net

operating income.
$85,000 $1,000,000
ROI = ×
$1,000,000 $625,000
= 8.5% × 1.6 = 13.6%
(Increase) (Decrease) (Decrease)
6. $80,000 $1,000,000
ROI = ×
$1,000,000 $320,000
= 8% × 3.125 = 25%
(Unchanged) (Increase) (Increase)
7. $60,000 $1,000,000
ROI = ×
$1,000,000 $480,000
= 6% × 2.08 = 12.5%
(Decrease) (Increase) (Decrease)
11-41

1. Both companies view training as important; both companies need to
leverage technology to succeed in the marketplace; and both companies
are concerned with minimizing defects. There are numerous differences
between the two companies. For example, Applied Pharmaceuticals is a
product-focused company and Destination Resorts International (DRI) is
a service-focused company. Applied Pharmaceuticals’ training resources
are focused on their engineers because they hold the key to the success
of the organization. DRI’s training resources are focused on their front-
line employees because they hold the key to the success of their
organization. Applied Pharmaceuticals’ technology investments are
focused on supporting the innovation that is inherent in the product
development side of the business. DRI’s technology investments are
focused on supporting the day-to-day execution that is inherent in the
customer interface side of the business. Applied Pharmaceuticals defines
a defect from an internal manufacturing standpoint, while DRI defines a
defect from an external customer interaction standpoint.
11-42

Applied Pharmaceuticals
Financial
Return on +
Stockholders’ Equity
Customer
Customer perception of + Customer perception of +

first-to-market capability product quality
Internal
Business R&D Yield + Defect rates –
Processes
Learning
and Percentage of job +
Growth offers accepted
Dollars invested in + Dollars invested in engineering +

engineering technology training per engineer
11-43
Destination Resorts International
Financial
Sales +
Customer
+
Number of repeat customers
Internal
Business Room cleanliness +
Processes
Percentage of Average time to

error-free repeat + resolve customer –
customer check-ins complaint
Learning
and Employee Employee morale +
Growth –
turnover as shown in
survey
Number of employees +
receiving database
training
11-44

3. The hypotheses underlying the balanced scorecards are indicated by the
arrows in each diagram. Reading from the bottom of each balanced
Applied Pharmaceuticals
o If the dollars invested in engineering technology increase, then the
R&D yield will increase.
o If the percentage of job offers accepted increases, then the R&D
yield will increase.
o If the dollars invested in engineering training per engineer increase,
then the R&D yield will increase.
o If the R&D yield increases, then customer perception of first-to-
market capability will increase.
o If the defects per million opportunities decrease, then the customer
perception of product quality will increase.
o If the customer perception of first-to-market capability increases,
then the return on stockholders’ equity will increase.
o If the customer perception of product quality increases, then the
return on stockholders’ equity will increase.
Destination Resort International
o If the employee turnover decreases, then the percentage of error-
free repeat customer check-ins and room cleanliness will increase
and the average time to resolve customer complaints will decrease.
o If the number of employees receiving database training increases,
then the percentage of error-free repeat customer check-ins will
increase.
o If employee morale increases, then the percentage of error-free
repeat customer check-ins and room cleanliness will increase and the
average time to resolve customer complaints will decrease.
o If the percentage of error-free repeat customer check-ins increases,
then the number of repeat customers will increase.
11-45
o If the room cleanliness increases, then the number of repeat

customers will increase.
o If the average time to resolve customer complaints decreases, then
the number of repeat customers will increase.
o If the number of repeat customers increases, then sales will increase.
11-46

Each of these hypotheses is questionable to some degree. For example,
in the case of Applied Pharmaceuticals, R&D yield is not the sole driver
of the customers’ perception of first-to-market capability. More
specifically, if Applied Pharmaceuticals experimented with nine possible
drug compounds in year one and three of those compounds proved to
be successful in the marketplace it would result in an R&D yield of 33%.
If in year two, it experimented with four possible drug compounds and
two of those compounds proved to be successful in the marketplace it
would result in an R&D yield of 50%. While the R&D yield has increased
from year one to year two, it is quite possible that the customer’s
perception of first-to-market capability would decrease. The fact that
each of the hypotheses mentioned above can be questioned does not
invalidate the balanced scorecard. If the scorecard is used correctly,
management will be able to identify which, if any, of the hypotheses are
invalid and the balanced scorecard can then be appropriately modified.
11-47

1. a., b., and c.
Month
1 2 3 4
Process time.................................... 0.6 0.6 0.6 0.6
Inspection time................................ 0.1 0.3 0.6 0.8
Move time....................................... 1.4 1.3 1.3 1.4
Queue time...................................... 5.6 5.7 5.6 5.7
Total throughput time...................... 7.7 7.9 8.1 8.5
Process time ÷ Throughput time....... 7.8% 7.6% 7.4% 7.1%
Delivery cycle time in days:
Wait time......................................... 16.7 15.2 12.3 9.6
Total throughput time...................... 7.7 7.9 8.1 8.5
Total delivery cycle time................... 24.4 23.1 20.4 18.1
2. a. The company seems to be improving mainly in the areas of quality

control, material control, on-time delivery, and total delivery cycle
time. Customer complaints, warranty claims, defects, and scrap are
all down somewhat, which suggests that the company has been
paying attention to quality in its improvement campaign. The fact
that on-time delivery and delivery cycle time have both improved also
suggests that the company is seeking to please the customer with
improved service.
b. Inspection time has increased dramatically. Use as percentage of

availability has deteriorated, and throughput time as well as MCE
show negative trends.
11-48

c. While it is difficult to draw any definitive conclusions, it appears that
the company has concentrated first on those areas of performance
that are of most immediate concern to the customer—quality and
delivery performance. The lower scrap and defect statistics suggest
that the company has been able to improve its processes to reduce
the rate of defects; although, some of the improvement in quality
apparently was due simply to increased inspections of the products
before they were shipped to customers.
3. a. and b.
Month
5 6
Process time........................................... 0.6 0.6
Inspection time...................................... 0.8 0.0
Move time.............................................. 1.4 1.4
Queue time............................................ 0.0 0.0
Total throughput time............................. 2.8 2.0
Process time ÷ Throughput time............. 21.4% 30.0%
As non-value-added activities are eliminated, the manufacturing cycle

efficiency improves. The goal, of course, is to have an efficiency of
100%. This is achieved when all non-value-added activities have been
eliminated and process time equals throughput time.
11-49
Case 11-23 (60 minutes)

1. Answers may differ concerning which category—learning and growth,
internal business processes, customers, or financial—a particular
performance measure belongs to.
Financial
Total profit +
Average age of Written-off

accounts receivable accounts receivable
 
as a percentage of
sales
Customer Customer
satisfaction with +
accuracy of charge
account bills
Internal Unsold inventory at
Business Percentage of
end of season as a
Processes charge account bills  percentage of total 
containing errors
cost of sales
Percentage of
suppliers making
+
just-in-time
deliveries
Learning
Percentage of sales
and
clerks trained to
Growth
correctly enter data +
on charge account
slips
11-50
Case 11-23 (continued)

A number of the performance measures suggested by managers have
not been included in the above balanced scorecard. The excluded
performance measures may have an impact on total profit, but they are
not linked in any obvious way with the two key problems that have been
identified by management—accounts receivables and unsold inventory.
If every performance measure that potentially impacts profit is included
in a company’s balanced scorecard, it would become unwieldy and focus
would be lost.
2. The results of operations can be exploited for information about the

company’s strategy. Each link in the balanced scorecard should be
regarded as a hypothesis of the form “If ..., then ...”. For example, the
balanced scorecard on the previous page contains the hypothesis “If
customers express greater satisfaction with the accuracy of their charge
account bills, then the average age of accounts receivable will improve.”
If customers in fact do express greater satisfaction with the accuracy of
their charge account bills, but the average age of accounts receivable
does not improve, this would have to be considered evidence that is
inconsistent with the hypothesis. Management should try to figure out
why the average age of receivables has not improved. (See the answer
below for possible explanations.) The answer may suggest a shift in
strategy.
In general, the most important results are those that provide evidence
inconsistent with the hypotheses embedded in the balanced scorecard.
Such evidence suggests that the company’s strategy needs to be
reexamined.
11-51

3. a. This evidence is inconsistent with two of the hypotheses underlying
the balanced scorecard. The first of these hypotheses is “If customers
express greater satisfaction with the accuracy of their charge account
bills, then there will be improvement in the average age of accounts
receivable.” The second of these hypotheses is “If customers express
greater satisfaction with the accuracy of their charge account bills,
then there will be improvement in bad debts.” There are a number of
possible explanations. Two possibilities are that the company’s
collection efforts are ineffective and that the company’s credit reviews
are not working properly. In other words, the problem may not be
incorrect charge account bills at all. The problem may be that the
procedures for collecting overdue accounts are not working properly.
Or, the problem may be that the procedures for reviewing credit card
applications let through too many poor credit risks. If so, this would
suggest that efforts should be shifted from reducing charge account
billing errors to improving the internal business processes dealing
with collections and credit screening. And in that case, the balanced
scorecard should be modified.
b. This evidence is inconsistent with three hypotheses. The first of these

is “If the average age of receivables declines, then profits will
increase.” The second hypothesis is “If the written-off accounts
receivable decrease as a percentage of sales, then profits will
increase.” The third hypothesis is “If unsold inventory at the end of
the season as a percentage of cost of sales declines, then profits will
increase.”
Again, there are a number of possible explanations for the lack of
results consistent with the hypotheses. Managers may have
decreased the average age of receivables by simply writing off old
accounts earlier than was done previously. This would actually
decrease reported profits in the short term. Bad debts as a
percentage of sales could be decreased by drastically cutting back on
extensions of credit to customers—perhaps even canceling some
11-52
charge accounts. (There would be no bad debts at all if there were no

credit sales.) This would have the effect of reducing bad debts, but
might irritate otherwise loyal credit customers and reduce sales and
profits.

The reduction in unsold inventories at the end of the season as a
percentage of cost of sales could have occurred for a number of
reasons that are not necessarily good for profits. For example,
managers may have been too cautious about ordering goods to
restock low inventories—creating stockouts and lost sales. Or,
managers may have cut prices drastically on excess inventories in
order to eliminate them before the end of the season. This may have
reduced the willingness of customers to pay the store’s normal prices.
Or, managers may have gotten rid of excess inventories by selling
them to discounters before the end of the season.
11-53

Performance Measurement in Decentralized Organizations: Solutions To Questions

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Performance Measurement in Decentralized Organizations: Solutions To Questions

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Chapter 11 Performance Measurement in Decentralized Organizations

moving, inspection, and other non-value-added activities.

Exercise 11-1 (10 minutes)

3. ROI = Margin × Turnover

Exercise 11-2 (10 minutes)

Exercise 11-3 (20 minutes)

2. Only process time is value-added time; therefore the manufacturing

4. Delivery cycle time = Wait time + Throughput time

Exercise 11-4 (45 minutes)

2. Employees focus on improving those measures that are used to evaluate

Exercise 11-4 (continued)

Time to fill – Customer satisfaction with +

Average change- Average

Exercise 11-4 (continued)

Exercise 11-5 (20 minutes)

Exercise 11-6 (15 minutes)

= 10% × 2.5 = 25%

2. Net operating income

$8,000,000 (1.00 + 1.50)

= 20% × 6.25 = 125%

Exercise 11-6 (continued)

= 10.5% × 2.5 = 26.25%

Exercise 11-7 (20 minutes)

Exercise 11-8 (15 minutes)

Company A Company B Company C

Exercise 11-9 (30 minutes)

2. Division A Division B Division C

Exercise 11-9 (continued)

3. a. and b. Division A Division B Division C

Exercise 11-10 (15 minutes)

Exercise 11-11 (45 minutes)

Revenue per employee + Sales +

Customer Customer Customer

Ratio of billable hours + Average time needed to –

Percentage of job + Employee morale +

Amount of compensation paid + Average number of years –

Exercise 11-11 (continued)

Exercise 11-11 (continued)

3. The performance measure “total dollar amount of tax refunds

Exercise 11-11 (continued)

Exercise 11-12 (30 minutes)

2. Net operating income

= 2.5% × 8.8 = 22%

Exercise 11-12 (continued)

4. Net operating income

Exercise 11-13 (15 minutes)

Problem 11-14 (30 minutes)

b. Under the residual income approach, Fred Halloway would be inclined

Problem 11-15 (30 minutes)

2. Companies in the Same Industry

Problem 11-15 (continued)

Problem 11-16 (30 minutes)

Manufacturing cycle efficiency (MCE):

2. The general trend is favorable in all of the performance measures

Problem 11-16 (continued)

As a company pares away non-value-added activities, the manufacturing

Problem 11-17 (45 minutes)

Financial Total profit +

Problem 11-17 (continued)

3. Management will be able to tell if a hypothesis is false if an

not, in fact, lead to improvement in the performance measure at the tip of

Problem 11-18 (20 minutes)

= 15% × 2.2 = 33%